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Has final countdown for bond bomb begun?

PUBLISHED: 21 Nov 2012 00:05:50 | UPDATED: 21 Nov 2012 04:20:07 Share Links: email print -font +font Duncan Hughes Investors dash to bonds and defensive stocks is inflating an ultimate bubble that could burst with disastrous consequences for portfolios still struggling to recover from equity losses, according to a former investment bank chief strategist and Bank of England economist. Ian Harnett, who is joint managing director of Absolute Strategy Research, a Londonbased asset consultancy, warns that a 30-year bull market in bonds has lulled many asset consultants and investors into a false sense of confidence. It is not surprising that the consensus, which uses backward looking return and volatility data currently has a preference for bonds over equities, says Harnett, who has been in Australia consulting superannuation funds and institutional investors. Government bonds are becoming the ultimate bubble, he says. Harnett, who has also led equity strategy teams for UBS and Bankers Trust, compared the rise in demand for bonds to the craze for off-balance sheet financing that contributed to the global financial crisis and collapse of Lehman Bros. The GFC was, in part, due to banks selling off their mortgage portfolios to their offbalance sheet entities which then sold their collateralised debt obligations back to the banks. In this case, central banks are buying their own governments debts. But who provides the central bank equity and legitimacy? It is the governments, he says. Fund flows into immediate annuities nearly doubled to $1.8billion in the year ending June 2011, according to Plan for Life. This issue is that with investors being sold the notion of the new normal where growth is weak and deleveraging slow, low interest rates create demand for yield, encouraging investors into bonds and defensive stocks, he says.

Andrew Peters, managing director of Semaphore Private, an independent financial adviser, says: Some financial advisers are looking at what performed well over the past three years and usingthat as the basis for their recommendations to their clients. Where there is a lot of investor activity, the institutions are likely to follow by pushing their range of bond funds and defensive stocks, Peters says. Harnett says bond yields have tended to link to 10-year compound nominal gross domestic production growth. The current divergence, helped by quantitative easing, looks unsustainable and suggests an equilibrium yield of 4 per cent, implying large capital losses for bond holders. Harnett, who partners in Australia with Morse Consulting, says the US Federal Reserves assurances that it expects to see rates stay low until 2015 is inflating the bond bubble, even if it is reducing the risk of an imminent crash. But the US governments efforts to reduce employment from about 8per cent to 6 per cent will require the introduction of expansionary growth policies making suppressing bond yields more and more expensive. It is not clear whether the sell-off in bonds will be dramatic, or slow, but usually, the bursting of bubbles does have some warning, Harnett says. Prices do start to move for a few months before rolling over aggressively. As we move into 2014 and 2015, things could get trickier. Some analysts have compared the situation to 1994 when a modest 0.25 per cent rise in US interest rates led to a wholesale dumping of bonds in Europe and east Asia, causing big losses on scores of highly leveraged funds that were positioned the wrong way. The lesson from 1994 was that when there is a bond shock, there are not many places to hide, Harnett says. Bubbles last longer than most people expect but when they unravel it can move pretty aggressively. Leading consultancies, such as Towers Perrin and Mercer, are warning fund managers and private investors to lower their exposure to global government bonds amid falling yields and increasing volatility. Graeme Miller, head of investment for consultancy Towers Watson, says most developed markets bonds after inflation have negative yields. People are hiding in safe assets, which include investment grade debt. We have advised many of our clients to review their asset allocation because it puzzles us why a negative return would be deemed a sufficient reward.

Dave Stuart, head of dynamic asset allocation for consultancy Mercer, says: Fear is currently a bigger motivator of people than greed. The question is whether bonds move into a bear market. Stuart believes long-term yields are unsustainable and the consequence of a very unusual economic situation around the world as central banks attempt to support European economies and the United States. If everything goes pear-shaped in Europe, the US or China then government bonds are one of the few things that tend to rally as virtually all else subsides. But investors are paying an awful lot of insurance for medium-term real returns. Harnett says the danger for investors looking for bond-like equities, such as consumer staples, which provide strong income from their dividends, is near-record valuation premia. Equities are very cheap relative to the past 30 years, especially using measures such as cyclically adjusted price/earnings. Even in Australia and the US, equities are still at levels seen in 1994. Also, contrary to what is generally believed, over the past 140 years equities tend to do well as the economy deleverages. Equity returns tend to trough close to the peak of the debt cycle and in the following 10 years, you have tended to see equity returns rise boosted by negative real interest rates. READ NEXT: Quest for dividends pushes volatility Visiting investment experts offer divergent views on nation Iron ore juniors varying health The Australian Financial Review Related News advertising advertising Financial Review Technology All the information you need Now free to access Read moreTopics Financial Markets /Bonds Markets , Financial Markets /Foreign Exchange Markets , Financial Markets /Equities Markets , Economy, Financial Services Industry /Banking & Finance advertising